A Reasonable Rate Hike for Now

December 17, 2015

Yesterday the Federal Reserve raised its short-term interest rate target by 0.25 percentage points to just under 0.50 percent, the first increase in nearly 10 years. This small move poses few risks by itself, but the bigger question is how much more rates will rise over the next year or two. Can the US economy continue to grow and create jobs with higher interest rates? If we do not raise interest rates now, will inflation rebound and force the Fed to tighten faster at a later date?

These are the questions that surely dominated the Fed's deliberations this week. At 5 percent, the unemployment rate has fallen to the level most economists equate with full employment. If the economy continues to create jobs at anything close to its steady pace of the past couple years, the unemployment rate will fall even further. 

The Fed must keep its eye on the labor market, balancing the rate of job creation with the rate of workers entering the labor market.

The big unknown is how many people currently not looking for a job (and thus not counted as unemployed) will be willing and able to accept employment as the job market strengthens. If the answer is "not many," then the Fed is already behind the curve; the economy will overheat and inflation will rise above 2 percent before long. 

On the other hand, if there is a large reserve of potential workers, then raising rates now will hamper their re-entry into employment and possibly even tip the economy into recession. The risk of tightening policy too fast seems more worrisome at present, but the risk of moving too slowly is not inconsequential.

Interest rate liftoff now is a reasonable choice. But the Fed must keep its eye on the labor market, balancing the rate of job creation with the rate of workers entering the labor market. Keep the initial pace of rate increases slow, less than 1 percent over the next 12 months. Pause if job growth slows too much and speed up if the labor force does not grow with the new job openings.

Inflation seems on track to return to its 2 percent target, but the Fed cannot afford to ignore any renewed material deviation, especially on the low side where we have been for most of the past few years. The Fed's statement yesterday provided some reassurance on this point, saying that it "will carefully monitor actual and expected progress toward its inflation goal."

The biggest threat to jobs is the US dollar, which has soared over the past year. Economic growth is still weak in many of our trading partners, and rising U S interest rates may put further upward pressure on the dollar next year. The dollar's strength is already holding back U S exports and the jobs they create. The Fed must calibrate future rate hikes carefully against further increases in the dollar, which are themselves a form of monetary tightening.

Getting back to a normal Fed interest rate, with some reversal in the dollar's climb, will require a healthier and more sustainable recovery in the rest of the world. Going forward, a normal policy rate will be closer to 3 percent than the old norm of 4 percent. Two key reasons for lower interest rates are the slower rate of population growth at home and abroad and the fact that developing economies are lending to, rather than borrowing from, the United States and other advanced economies. Neither of these factors looks likely to change soon.

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Joseph E. Gagnon Senior Research Staff

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